Spain Update: Running from the Bulls?

There have been three recent developments in Spain: the new record high unemployment, the earnings reports of several large banks, and the government's new fiscal forecasts and strategy. Spanish 10-year yields continued to trend lower over the course of the week. The roughly 35 bp decline in yield brings the drop since early February to about 120 bp and 150 bp from a year ago. The 2-year yield is slipped below 2% for the first time since 2010. The 5-year credit default swap, the price of insuring sovereign exposure, has fallen from 470 bp a year to a little than 250 bp. Given that the Outright Market Transaction scheme of the ECB's , (which the Bundesbank opposed at the time and reportedly wrote a note to the Germany constitutional court trying to persuade it for a upcoming ruling), has not been implemented, the decline in Spanish yields is impressive. The Spanish economy remains in dire straits. Unemployment has continued to rise and in Q1 stands at a record high of 27.2% after 26% in Q4 12. More than 100k people are losing their jobs a month. Spain has the second highest unemployment rate in the euro area behind Greece. This is part a function of what is happening in Spain, but is also a larger issue. Core countries like France and the Netherlands has also reported deteriorating labor market conditions and rising unemployment. One response has been large scale emigration of the 16-30 year old cohort to 260k last year. A brain drain and exportation of skilled workers has a desultory impact on the hopes of a longer-term vibrancy of the Spanish economy. In recent days, several of Spain's largest bank issued Q1 earnings reports. There were a few common themes. First, non-performing loans continue to rise. For Banco Santander, Spain's largest bank, non-performing loans rose to 4.76% from 4.54% at the end of last year. The NPL ratio rose to 5.3% at BBVA, Spain's second largest bank, from 5.1%. Both of these banks have extensive overseas operations. The NPL problem at the more domestic banks, like Bankia and Caixabank rose to 13.1% and 9.4% respectively. Second, this in turn is forcing many banks to boost loan-loss provisions. Santander is an exception as they reduced their provisions. BBVA, for example, increased its provisions by 26%. Caixabank doubled its provisions. Third, net interest income is poor, reflecting shrinking margins. The is concern that another rate cut by the ECB, which is widely expected next week (though see here for a contrarian view), would further undermine the profitability of Spanish banks. Many loans, including mortgages, have variable rates, such links to 12-month Euribor, which has fallen by nearly 2/3 from a year ago. BBVA reported a 0.8% increase in interest income in Q1 and this is the exception that proves the rule. Santander reported a 17% decline in net interest income, while Bankia reported a 39% drop. Fourth, the international diversification of Spain's largest two banks cuts both ways. Santander saw a 22% decline in income from lending in Brazil (which cost 500 mln euros) and a 23% decline in the UK (accounted for about 225 mln euros). It interest income from Spain actually edged higher. BBVA realized a one time gain from the sale of a Mexican pension business line and booked profits from a reinsurance agreement. Fifth, retail and corporate deposits rose in Spain and this may have helped Santander and BBVA repay borrowings from the ECB. Santander has repaid 31 bln euro of the LTRO and BBVA has paid back 22 bln euros. Spanish banks reliance on central bank liquidity has fallen dramatically. At the end of Q1 it stood at 140 bln euros, down from a peak of 412 bln euros last August. The Spanish government updated its GDP forecasts by slashing them today. This year's contraction is put at 1.3% instead of the optimistic 0.3% decline anticipated in September. Next year's growth has been marked down to 0.5% from over 1%. Unemployment is not expected to peak for more than a year. An implication of this, which the government did not shy away from, is that its budget deficit will overshoot EU targets. Recall, last year's deficit was 10.6%, when the bank recapitalization is included and 7.1% without it. This year's shortfall is projected at 6.3% rather than the EU's target of 4.5%. The 2014 and 2015 deficit is now seen at 5.5% and 4.1% respectively. A sub-3% deficit is forecast for 2016. Spain is clearly taking the two-year extension that the EU has hinted it was considering. Part of the leeway that Brussels will give to Spain, Madrid will extend to the regions. Their deficit target this year was raised to 1.2% from 0.7%. Some new initiatives were announced, especially promoting small and medium sized businesses and their exports. There will be also some modification of taxes linked to the environment at the urging of the EC. However, there is no shock and awe here. The new initiatives are quite modest. There was little market reaction to Spain's announcement. Many of the details had been leaked. Next the EC will publish its new forecasts on May 3 and will review the national budgets and economic policy and make its recommendations on May 29. Just yesterday it warned that "excessive macroeconomic imbalances" remain. Although financing conditions are tight, it is not clear that an ECB refi rate cut would do more harm than good in Spain.